Locked box versus completion accounts
There are several possible price-setting mechanisms for a transaction. The locked-box mechanism has gradually gained ground in Europe over the last few decades, particularly when the transaction involves one or more investment funds. In the United States, transactions are still traditionally carried out on the basis of completion accounts. However, American private equity funds, which have become accustomed to the locked-box concept in European sales processes, are increasingly opting for the latter mechanism.
For these funds, this practice offers a number of advantages: a secure transaction with a price fixed at the signing date, greater comparability of bids when negotiation processes involve several potential candidates, faster transfer of sale proceeds to investors once the transaction has been completed, and a lower risk of dispute over the terms of the transaction post closing.
How the locked box works
At the signing date, the parties agree on the final acquisition price, using the latest audited financial statements (which will be covered by the guarantees), and do not provide for any post-closing adjustments. The economic risk is thus transferred to the acquirer at the time of signing, even though the seller still has control of the company. The basic mechanism is thus generally considered to be favorable to the seller; however, the seller’s commitments may lead to the transaction rebalancing.
The equity bridge is negotiated on the basis of due diligence carried out by the acquirer during the sales process, which generally includes a sufficiently long period before the submission of binding offers. In the absence of post-closing adjustments, the contract includes non-permitted leakage provisions, in order to preserve the target’s value between the selected locked box date and the closing date.
A mechanism often inappropriate for carve-out transactions…
The implementation of this mechanism proves to be complex in certain situations, notably in the case of transactions requiring a prior carve-out of the businesses to be sold, especially when the carve-out has not been finalized at the time the binding offers are submitted and, a fortiori, at the signing date. Even if the main assets have been clearly identified by the acquirer, the latter must not underestimate the due diligence required to ensure the quality of the accounting and financial information made available.
Carve-out transactions involve a number of difficulties and uncertainties, resulting in increased risks for the purchaser, and often rendering this pricing mechanism inappropriate:
- absence of a reference balance sheet for the initial locking of the box, or existence only of pro forma accounts unsuitable for setting up guarantees;
- the acquirer’s limited visibility of the acquired perimeter at the time of signing, which could lead to a poor estimate of the enterprise value and/or an error in the design of the equity bridge;
- complexity of the carve out process, leading to a risk of delay between signing and closing;
- difficulties in isolating the cash flows of transferred activities and/or the existence of intra-group flows, implying a higher risk of a value leakage which would not have been properly covered by the non-permitted leakage clauses included in the SPA.
… but sometimes compatible and advantageous in relation to the completion accounts mechanism
In certain cases, however, it may be possible to set up a locked-box mechanism. Before ruling out or definitively opting for this mechanism, the parties must carefully consider the benefits and constraints of each pricing method in the operation schedule, and determine whether the target’s characteristics and the carveout process are compatible with the locked box.
This mechanism is of particular interest in the context of restructuring a company in difficulty, to secure the transaction price and give visibility to the various stakeholders (minority shareholders, creditors, etc.) as well as to the governance bodies required to make arbitrations within a tight timeframe. By facilitating the execution of the transaction, the acquirer can hope concessions on the financial terms of the deal. The reinforced due diligence prior to the signing date, and the interactions that the acquirer is likely to have with the target company regarding the carveout process, can also be beneficial and lead to the identification and resolution of certain issues prior to closing.
The degree of complexity is determined by answering to the following questions:
- were the transferred activities historically located in separate legal entities with their own accounts?
- Alternatively, can cost accounting be used to link income and expenses, as well as assets and liabilities (including accounts receivable and payable, which underpin WCR), to the target company’s various activities?
- does the target hold mixed assets and contracts (i.e. relating both to the transferred activities and to other activities retained by the transferor)?
- what is the nature of intra-group flows (commercial agreements concluded at arm’s length, rebilling of support functions and/or intra-group financing balances)?
- has the target obtained the agreement of all its co-contractors for the planned transfer of control?
- will the target maintain relations with the group once the carveout has been completed?
- is the carveout process sufficiently controlled not to jeopardize the overall operation schedule?
- are the transferred activities subject to a high degree of seasonality, making it difficult to set a contractual working capital target?
If a locked-box mechanism is set up, the parties will need to find ways of limiting the potential impact of the risks identified, and the acquirer will need to be particularly vigilant about the quality of the information used if he does not have a sufficiently reliable track record.
Designing a locked box in a carveout deal
When the carve-out has already been finalized at the signing stage, the parties can set up a locked box in the conventional way. In the absence of formal accounts at the time of signing, it’s not so much a question of locking the box (in progress!), as of defining its future contents.
If the signing takes place before the carveout completion, the parties will generally agree on a target WCR deemed to correspond to the “normative” needs of the routed business . If this requirement is underestimated, the purchaser will have to finance the surplus, resulting in a de facto transfer of value from the purchaser to the seller. In the event of seasonal fluctuations in activity and/or uncertainties in the carveout schedule, setting a contractual target may prove ineffective. The parties can supplement the contractual provisions with rules designed to control customer and/or supplier payment terms, although the target company can often influence invoicing rythms. Furthermore, as the final acquisition price is no longer completely fixed, the parties can insert exit or “walk away” clauses into the acquisition contract to mitigate the risks associated with significant adjustments to the acquisition price.
In general, hybrid price-setting mechanisms can be envisaged, with, for example, the adjustment of certain equity bridge components on the basis of an accounting situation established at a later date. In any event, the constraints and risks associated with the price-setting mechanism chosen should be examined as early as possible in the sale process, so that they can be effectively managed within the legal framework of the transaction.
 In the absence of recent audited financial statements, the parties sometimes refer to unaudited interim financial statements reviewed by the acquirer as part of its due diligence.
 When the transferred activities are not located in separate legal entities, the cash package included in the carve-out is generally determined on the basis of negotiation, and often corresponds to the level of cash required to ensure the continuity of operations and guarantee the autonomous functioning of the branch.
 When the acquisition contract provides for symmetrical adjustments, an actual WCR below (above) the target level leads the transferor (the acquirer) to compensate the acquirer (the transferor).